What You Need to Know to Stay Compliant and Avoid IRS Trouble
If you own more than 2% of an S corporation, you are not just another employee. You’re subject to a special set of tax rules that many business owners—and even their advisors—get wrong.
Getting these rules right can help you avoid IRS penalties, save on taxes, and keep your S corp in good standing.
What Is an S Corporation?
An S corporation is not a business structure; it’s a tax election made by filing IRS Form 2553. That means your business could be an LLC or a corporation that chooses to be taxed as an S corporation.
S corps are pass-through entities. That means income, losses, deductions, and credits pass through the business to your personal tax return—avoiding corporate-level tax.
Why Does 2% Ownership Matter?
Once you own more than 2% of an S corp, you’re no longer treated like a regular employee. The IRS applies special rules to how you receive benefits, take deductions, and report income.
If you don’t follow these rules, you could face:
Lost deductions
Back taxes and penalties
An increased audit risk
Here are the most important areas where greater-than-2% shareholders must be cautious.
Health Insurance
S corps can pay for your health insurance, but you must handle it correctly.
The S corp pays the premiums or reimburses you.
The full premium amount must be added to Box 1 of your W-2 (but not Boxes 3 or 5).
You may deduct it on your personal return, as an above-the-line deduction, if eligibility rules are met.
If the W-2 reporting is done incorrectly, the IRS may disallow your deduction entirely.
Fringe Benefits
Many fringe benefits that are tax-free for regular employees are taxable for greater-than-2% shareholders. These include:
Employer-paid disability insurance
Group-term life insurance over $50,000
Personal use of a company car
Commuter benefits and meals
You must include the value of these benefits in your W-2 income. Failure to do so can result in back taxes, penalties, and interest.
Accountable Plans
An accountable plan lets employees get reimbursed for out-of-pocket business expenses tax-free. That generally does not apply to you.
For greater-than-2% shareholders:
Reimbursements may need to be included in wages.
Deducting those expenses personally is difficult because most were eliminated under the 2017 tax reform unless you itemize and qualify under strict limits.
A better strategy may be to build these costs into your compensation.
Company Vehicles
If you drive a company-owned vehicle, you must track business vs. personal use.
Personal use must be calculated and included as income.
Keep mileage logs and apply IRS-approved valuation methods.
Without records, the IRS may treat 100% of the use as personal—and fully taxable.
Shareholder Loans
It’s common for owners to loan money to their business, especially during growth phases or tight cash flow.
To avoid issues:
Prepare a promissory note
Use an arm’s-length interest rate
Record it as a loan, not capital, in the company books
Improper documentation may cause the IRS to treat it as a capital contribution or disguised compensation. This affects your basis for taking losses or tax-free distributions. Annual basis tracking is essential.
Cafeteria Plans and HSAs
Greater-than-2% shareholders cannot participate in tax-free cafeteria plans, including:
Health FSAs
Dependent Care FSAs
Pre-tax HSA contributions
HSA contributions must be made post-tax but may still be deductible on your individual return if other rules are met.
Reasonable Compensation
The IRS expects shareholder-employees to pay themselves a reasonable salary if they are actively involved in the business.
Your salary should reflect:
Industry standards
Duties performed
Revenue generated
Paying too little increases the risk of an audit and potential reclassification of distributions as wages.
We offer formal Reasonable Compensation Surveys based on IRS and industry benchmarks. These should be updated annually or when your role or income changes.
What Happens If You Get It Wrong?
Deductions may be disallowed
You may owe back payroll taxes, penalties, and interest
The IRS may reclassify distributions as wages
In extreme cases, your S corp status may be at risk
What You Should Do Now
Review your W-2. Are fringe benefits and insurance premiums reported correctly?
Check whether you’re being paid a reasonable salary.
Review any loans to or from the company. Are they documented properly?
Reassess your basis tracking. Are you keeping up with annual updates?
If you’re unsure about any of this, don’t guess. Get it right now—before year-end planning turns into IRS cleanup.
Let's also take a closer look at whether the S-corp structure is still the best choice for your business at this time. Our expert analysis can help you decide if you should stick with your current setup or explore other options for the most tax-efficient path forward.
Call us to schedule your review today to ensure your business is optimized and fully compliant.
This post is for informational purposes only and does not constitute legal, tax, or investment advice. Please consult a qualified professional for personalized guidance.